IRS Surprises Retirement Plan Heirs With Tax Reprieve

Recent heirs to retirement plans got an unexpected boost last month when the Internal Revenue Service suggested they could skip making required withdrawals for this year and last. The tax agency surprised wealth advisors in early October when it announced that people would not face the 50% penalty for not taking minimum distributions from inherited plans, such as individual retirement accounts, for 2022 and 2021. Though the IRS did not spell things out directly and said final rules would come next year, the announcement appears to mean that heirs are permanently off the hook for withdrawals for those two years.

Under a 2019 law, beneficiaries who are not spouses, minor children, chronically ill, disabled, or not more than 10 years younger than the plan’s owner must drain inherited accounts, whether traditional or Roth, within 10 years. The law hits beneficiaries of inherited plans whose original owner died after 2019. Withdrawals from traditional IRAs and 401(k)s, whose contributions are made with dollars on which taxes have not yet been paid, are taxed at ordinary rates of 37%. If beneficiaries do not make a minimum withdrawal each year, there is a 50% penalty, plus interest, on the minimum amount not taken.

The 10-year rule is a significant shift for the estate planning industry. With the IRS not enacting the 50% penalty, plus fees, more money can compound over a decade. However, not withdrawing the funds can also create a tax time bomb. This means heirs will pay larger tax bills because they have to pull out more significant amounts over a shorter period. Heirs to Roth plans, funded with dollars on which taxes have already been paid, do not owe any tax on withdrawals, but they still have to drain the accounts within 10 years.

What is evident in the IRS’s reprieve is that heirs who are not a surviving spouse, chronically ill, disabled, or a child do not have to make minimum withdrawals this year and last before draining the accounts within 10 years. While spouses, sick people, and children must still take required annual distributions, including for 2021 and 2022, they can do so over their lifetime; a child gets hit with the 10-year rule once they turn 18. The notice makes clear that beneficiaries that are trusts, estates, and charities are off the hook for withdrawals for 2021 and 2022. 

The federal government requires owners of non-inherited IRAs, 401(k)s, and other defined-contribution plans whose tax bills are deferred until withdrawals are made to pull out a minimum each year once they reach age 72. Taxpayers must generally take a required first distribution by April 1 of the year after they reach age 72. No annual withdrawals are required for original living owners of Roth plans because they are funded by dollars on which taxes have already been paid. While a 2019 law raised the age at which taxpayers must make their first withdrawal to 72 from 70½, taxpayers born before July 1, 1949, are subject to the lower age limit. Older people still employed and contributing to an employer-sponsored retirement plan can delay the first withdrawal from that account until April 1 after they retire.

Talley’s team of tax professionals provide comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.

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